The Role of Government: Economic Planning and Political Economy

China’s rapid economic growth appears to contradict and defy classical economic and finance theories that promote individual self-interest and free market capitalism. Its central economic planning, particularly through mechanisms like the Five-Year Plans and state-owned banking system with preferential treatment of SOEs, has resulted in both economic growth and inefficiencies in resource allocation. Local governments, tasked with implementing these plans, frequently prioritize short-term gains over long-term sustainability. Therefore, it is critical for us not only to recognize the important role played the central government but also to pay attention to the effects of decentralization of economic and fiscal power from central to local governments. This chapter provides a historical perspective on how the state used the Five-Year Plans to plan the economy and subsidize industry, and how the politically-motivated lending by state-owned banks caused wasteful investment by the state-owned enterprises. It then investigates the rationale behind the decentralization of fiscal policy from the central to local governments, and the interplay among local government finance, real estate markets, and off-budget activities in land sales.